On Feb. 5, 2018, the S&P 500 stock market index fell 113 points, or 4.10%, to 2,648.94, while the VIX index that tracks changes in underlying market moves jumped to a stunning 37.32, up a historic 116%. That same day, the Dow Jones Industrial Average crashed 1,175 points to hit 24,345.75.
This woke up most market watchers, made more than a few traders weep with joy and shook up many investors. The 17 investment experts and advisors who shared their views with Investment Advisor, though, had this sober take on the development: The “new” volatility is normal, and the smooth sailing investors have been experiencing over the past year or so is not normal. In other words, don’t panic.
“Today’s volatility is normal per past periods — except for the past two years,” said Brad McMillan, chief investment officer of Commonwealth Financial. “We have gotten used to a much calmer environment recently, which has created a false expectation that the market really is calm. In fact, what we are seeing now is much more normal than 2017 was — and we better get used to it.”
In fact, 2017 didn’t see a drop of more than 3% for the entire year, notes Andrew Crowell, vice chairman of D.A. Davidson. “We went 404 days without a drop of 5%. This is highly unusual,” he said, adding that for the eight years since the end of 2009, the S&P 500 increased 138% (not including dividends), or 11.4% annually.
During that same eight-year period, the S&P 500 index dropped by at least 5% on 14 separate occasions. “Each time, however, the bull market remained intact, and the market ultimately went to new highs,” he explained.
Plus, since 1980, the largest annual pullback experienced in each year has averaged -14.9%. “Even in bull market years, it is normal to have an 8-12% pullback within the year,” said Mike Gibbs, director of equity portfolio and technical strategy for Raymond James. “The recent 2018 pullback was sharp — but within the normal range — as the S&P 500 contracted -11.8% in 10 days from its peak to intraday low.”
Randy Rae, manager of investment strategy and research for the wealth management firm Aspiriant, agrees this year’s volatility isn’t different, although the move was “unusually swift.” He adds that it’s “healthy for the markets.”
This “new” volatility shouldn’t surprise investors. But given that many market fundamentals are still sound, why did it emerge?
A Bumpy Start to 2018 The Volatility Index, or VIX, which measures the implied volatility of the S&P 500 index, jumped 116% on Feb. 5 while the S&P 500 index plunged more than 4%. Volatility was picking up before the spike, and has remained active since.
“It’s driven more by secondary factors than direct recession risk,” said John Lynch, executive vice president and chief investment strategist of LPL Financial. These include a new Federal Reserve chair, a “modestly hawkish” Fed member-ship as well as those who agree with a lighter touch on regulation, a long “unprecedented” period of extraordinarily low volatility, and mid-term elections in the wings, he says.
Long-term periods of low volatility “eventually make the market more sensitive to catalysts,” and mid-term election years “tend to be more volatile,” according to Lynch. “Throw in recent policy risks around trade as a kicker,” he explained.
Still, the Dr. Jekyll and Mr. Hyde action by the VIX certainly should cause pause, notes Grant Jaffarian, portfolio man-ager at Crabel Capital Management, LLC.
“The existence of two completely different volatility scenarios, all within about a six-week stretch, makes it hard to argue against market volatility looking somewhat ‘different’ than it has in the past. The ‘why’ is difficult to answer with certainty,” Jaffarian said. Still, he believes there are several post-2008 factors that are commonly overlooked.
First, “There has been a constant and deep flow of assets into products that end up operating in similar ways,” the portfolio manager explained. At least four broad categories of investments “have theoretically hastened a volatility reduction across global markets,” he says.
Examples of strategies that could operate as “volatility dampening” inflows include beta products that target market returns like the S&P 500; alternative-beta vehicles that target market inefficiencies in a rules-based fashion, such as value equity investing; risk-parity oriented investments that aim to frequently rebalance for several market “beta” returns like equity risk, fixed income, etc.; and trend-following funds that target momentum across several asset classes.
“While fairly different in posture, all these vehicles can exhibit very similar characteristics in low-volatility environments,” Jaffarian said. “As volatility declines and long-term trends extend, as it has been seen in the case of equity indices, exposures slowly rise to big volatility targets and/or as a function of inflows.” This action “remains true, theoretically, until it doesn’t, at which point redemptions, volatility adjusting and unwinding could create the opposite effect,” he added.
Second, before 2008, bank proprietary trading desks provided a big chunk of market liquidity. Post 2008, that mantle — like it or not — often has been taken up by high frequency traders. “They do not play with house money, but their own money,” Jaffarian said. As such, if the market environment does not suit their trading, they may widen spreads or even chose to sit on the sidelines for “a couple minutes or hours,” which can further exaggerate market swings.
Due to these two factors, advisors and investors should be ready for “longer stretches of collapsing volatility followed by shorter and yet far more severe bursts of volatility,” Jaffarian says.
Rising volatility is one of Pinnacle Advisor Solutions “themes” for 2018, according to Chief Investment Officer Rick Vollaro. The only “real wrinkle” of the February correction was that some investors got caught up in the unwinding of a trade that was betting on continued low volatility, he says.
“The speed of the correction makes this feel different,” Vollaro explained. “But that probably is due to the combination of the overbought state of the market prior to the correction, the volatility unwinds and computer programs that tend to amplify moves in either direction.” (See “The VIX & Other Fear Gauges”)
Aging Market Cycle? Most, but not all, portfolio experts and advisors who spoke with IA agree that we are in a late stage of the current market cycle — maybe.
“It’s an odd cycle,” LPL’s Lynch said. “Margins, employment, Fed tightening and the start of higher inflation point to a late cycle, and that’s where we are big picture. But coordinated global growth and earnings reacceleration off of the crash in oil put us closer to mid [cycle]. Fiscal stimulus, which is completely out of joint for this point in the cycle, points to an early [cycle]. Call it a late cycle, but it’s not a normal late cycle.”
Other managers concur. “It’s not easy for fundamental investors to understand where we’re at in this cycle,” said Dan McNeela, senior portfolio manager and co-head of target risk strategies at Morningstar Investment Management. “To do so is always murky, but extremely low interest rates have muddied the water.”
Brad Thompson, chief investment strategist of Frost Investment Advisors, explained, “We are in an early late cycle but a recession is not imminent.”
This late-stage bull market and business cycle seem to have legs, according to some investment experts. For example, though he believes we are in a mid-to-late bullish cycle, Probabilities Fund Management CEO Joe Childrey sees the market in the middle of a longer-term bull run “as the market climbs the wall of worry.”
“There are always ‘this time is different’ events and potential black swans, so a correction or bear market could hap-pen anytime,” he explained. “But as far as valuations, business cycle and employment numbers, the market looks good. We might get some competition from the bond market when 10-year Treasuries reach 5-6%, but we are not even close to those yet.”
Big Moves Through Century
Feb. 5, 2018 may have been the largest drop point-wise in the history of the S&P 500, but it doesn’t even hit the top 10 big moves by percent. Black Friday still ranks as the largest drop of the S&P 500 in its history, falling 20.47%. However, the two other eras that ranked most volatile were the Great Depression starting in 1929, and the Financial Crisis of 2008.
Source: Standard & Poor’s
High growth rates and tight capacity will stimulate inflationary pressures and interest rates, Vollaro says. Plus, the late-cycle fiscal stimulus that is expected “should give the economy a jolt and may intensify inflationary tendencies that are already building in the system,” he explains. “We believe the markets are wrestling with the dynamics of this economy in transition.”
One force behind this stimulus is tax reform, which has changed the game and economic outlook, according to C.J. MacDonald, senior vice president and portfolio manager at Westwood Wealth. Before tax reform, “We were in the late stages of a normal business cycle with a small amount of market upside to go. However, the tax law changes were so significant to both consumers’ pocketbooks and Corporate America’s bottom lines that we look for the economy to show strong numbers again this year,” he explained.
2018 Expectations Expect more of the same volatility we’ve experienced in the first couple months of 2018, many experts say, particularly because the market has returned to “normal” volatility. Rae defines “normal” as the stock market dipping 5% or more at least a couple times during the year and the VIX remaining higher than in 2017.
No doubt, market participants will be “on edge and will be trying to divine the next big shift with each significant economic data point, earnings release, or Fed statement,” explains Cliff Stanton, chief investment officer of 361 Capital. “As such, we expect 2018 to be far more volatile than 2017 and much more in keeping with historical equity vola-tility patterns.”
Market activity in the first six weeks of 2018 is “a likely predictor of continued volatility for the balance of the year,” according to Crowell. This means more market spikes, as well as profit taking that could add to volatility.
The new tariffs President Donald Trump imposed should add to the increased volatility, says John Toohey, head of equities for USAA: “We expect higher volatility due to burgeoning signs of inflation, a Federal Reserve that will likely be less accommodative, and an overhang of potential tariffs on trade that could end the long period of globalization and the economic stability that came with it.”
Keeping an eye on the VIX Index is imperative for both advisors and investors, some managers point out. For example, one reasonable scenario is there is “a general decline in volatility back to a less than 10 VIX within the next quarter that is sustained till the end of the year,” Jaffarian says.